How Does CVS Caremark Boost Its Returns?

As investors, we need to understand how our companies truly make their money. A neat trick developed for just that purpose -- the DuPont Formula -- can help us do so.

So in this series we let the DuPont Formula do the work. Let's see what it can tell us about CVS Caremark (NYS: CVS) and a few of its peers.

The DuPont Formula can give you a better grasp on exactly where your company is producing its profit, and where it might have a competitive advantage. Named after the company where it was pioneered, the formula breaks down return on equity into three components:

Return on equity = net margin x asset turnover x leverage ratio

What makes each of these components important?

High net margins show that a company can get customers to pay more for its products. Luxury-goods companies provide a great example here.

High asset turnover indicates that a company needs to invest less of its capital, since it uses its assets more efficiently to generate sales. Service industries, for instance, often lack big capital investments.

Finally, the leverage ratio shows how much the company is relying on liabilities to create its profits.

Generally, the higher these numbers, the better. That said, too much debt can sink a company, so beware of companies with very high leverage ratios.

Wal-Mart has the highest returns on equity of these companies. Its net margins are comparable with those of CVS Caremark and Walgreen, and its asset turnover falls in the middle of the pack, but its leverage ratio is higher than the others'. Walgreen's ROE is not far behind Wal-Mart's, and it even earns a higher margin than the Bentonville Behemoth, but its lower leverage pulls down ROE. CVS Caremark's ROE is less than half Walgreen's. While its net margins are not terribly lower than Wal-Mart's, it has the lowest asset turnover and the second lowest leverage ratio. Rite Aid's ROE is not meaningful, because it has a negative leverage ratio. However, its asset turnover is the highest of these companies.

CVS, unlike Rite Aid, has kept its debt levels reasonable while offering some good growth in recent years. It has also benefited from negative attention on Medco Health as it was being investigated for possible improprieties. This allowed CVS to take over the CalPERS public employee pharmacy benefits management business. CVS also bought Universal American's Medicare Part D business, which has allowed it to grow its health-care benefit division.

CVS's challenges going forward include the need to find ways to continue winning contracts in the face of a possible merger between Medco and Express Scripts (NAS: ESRX) , which could eat into CVS's market share. However, growing resistance to this merger, including a request from big grocery chains to stop it, is starting to make the deal look less likely to go through than originally anticipated.

Using the DuPont Formula can often give you some insight into how a company is competing against peers and what type of strategy it's using to juice return on equity. To find more successful investments, dig deeper than the earnings headlines.